Twitter's Got A Revenue Conundrum

Valuations have ranged from the ridiculous to the sublime in the days following the Tweet Heard Around The (Social Media) World in mid-September when the company announced it was going public in an appropriately brief, 140-character tweet. Now that its S-1 registration statement is out; the predictions are only going to multiply in number getting more difficult to swallow.

But forget about what Twitter's worth for a second.

Instead, focus on the reality that advertisers aren't sold on its social media platform being the right vehicle to reach their target customers. While it's true a majority of its users are mobile in nature, there just aren't enough of them to convince the big global brands to abandon Facebook (Nasdaq:FB) and other social media sites.

It doesn't have a valuation problem. Rather, it faces a revenue conundrum. Here's why.

Lack of Profits

Google's (Nasdaq:GOOG) revenue was $1.47 billion when it went public in August 2004. Facebook had annual revenue of $3.71 billion when it IPO'd in 2012. Both were considerably larger than Twitter in terms of revenue(2012 revenue $317 million) when offering its shares to the public. Not only that but they made money — something Twitter does not.

Twitter has 218 million monthly active users (MAU) who each generate $1.47 in annual revenue. That's an operating loss of 35 cents per user. When Facebook went public it had 901 million MAUs each generating $4.11 in annual revenue and $1.96 in operating profit. And that was with absolutely no mobile ad revenue. Today, Facebook generates about 41% of its ad revenue from mobile devices (compared to 65% for Twitter) thanks to 819 million mobile users.

Based on first-half results at the end of June, Facebook's annualized revenue and non-GAAP operating profit per MAU is $5.69 and $2.37, respectively. Since its IPO in May 2012 it's been able to increase monthly active users by 28% to 1.15 billion. It now has five times the users Twitter does. Of even greater importance is the fact that Facebook has grown its MAU's on an annualized basis by 11.5% over the past 27 months.

Meanwhile, Twitter's annualized growth rate in terms of MAUs was just 7% in its most recent quarter, much less than the 10%-11% it was averaging previously. I don't know what Twitter's break-even point is in terms of MAUs but it's definitely greater than 218 million. If it can't grow its user base faster than Facebook, which clearly has an edge with advertisers, this competition is over with almost before it's begun.

Advertisers Hesitant

The Wall Street Journal published an interesting article October 4 that highlights the concerns advertisers have with Twitter and why they currently favor Facebook. There's obviously the issue of reach — Facebook has five time's as many users. Progressive Corp. (NYSE:PGR) chief marketing officer Jeff Charney is quoted in the article: "The 200 million-plus Twitter Nation is a powerful and influential source that you have to pay attention to…But Facebook has 'more heft.' You just can't ignore Facebook."

Internationally, it's clear Twitter has some catching up to do. In the first six months of 2013 it generated 25% of its revenue outside the US. The year before Facebook went public it was generating 44% of its revenue internationally; more importantly, it was making money. Furthermore, by the time Twitter prices its IPO it will have existed for close to eight years, not much different then Facebook's nine years when it went public in 2012. Any argument that Facebook was far more advanced in its history as an explanation for the difference in international revenue and general profitability just doesn't cut it.

Research & Development

What should really jump out at you is Twitter's research and development costs. Forget MAUs and DAUs (daily active users) and consider that its R&D in the first six months of the year was 44% of its overall revenue and has been no lower than 38% in the past three years. Facebook's R&D costs as a percentage of revenue have stayed within a range of 10% and 20% with the exception of the second quarter of 2012 when it hit 60% due to restricted stock units (RSUs) being triggered by Facebook's IPO. Twitter hasn't even gone public and its share-based compensation is through the roof. In addition, approximately $1.3 billion in recognized and unrecognized share-based compensation for pre-2013 RSUs will begin to be recorded once it's a public company. The losses in the first few quarters will be tremendous.

Bottom Line

Facebook, Google, LinkedIn (Nasdaq:LNKD), Yahoo (Nasdaq:YHOO) — Twitter has a lot of competition. Facebook went public with investors doubting it could generate mobile advertising. According to TechCrunch, Facebook now has 15.8% of the global mobile ad market. Twitter's approximately $425 million in mobile ad revenue in 2013 represents approximately 2.6% global market share. Google, the champion of mobile ads, has 53.2% market share. Facebook and Google combined have 27 times the market share of Twitter. And that's with Facebook starting from scratch two years ago.

Despite the obvious headwinds, Twitter's IPO success seems likely. Investors just don't seem to care that its future revenue generation is severely impacted by Facebook's growing dominance in the mobile ad market. The messaging service might get a $20 billion valuation when it goes public but that doesn't mean it has to stay there once it begins trading.

Investors were skeptical of Facebook when it went public despite being profitable. Twitter's not and yet investors are clamoring for its stock. Go figure.

Disclosure - At the time of writing, the author did not own shares of any company mentioned in this article.